New Pensions for New Times

The California Public Employees' Retirement System (CalPERS) has announced a return of only 1.1 percent on its investments during calendar 2011, and the fallout offers the latest evidence that traditional state pension plans no longer are sustainable.

You've heard the horror stories about huge unfunded liabilities. In 2010, California's total pension funding gap (including separate systems for teachers and University of California employees) was estimated at anywhere between $59.49 billion and $425 billion--and that's for a state whose assets were sufficient to fund 81 percent of future promises made as of fiscal 2009, when the national average was 78 percent.

Much of the problem with state pension systems stems from sins of the past. In Massachusetts, taxpayers paid about $306 million to fund current pension costs last year, but more than $1.1 billion to pay down previously accumulated liabilities.

The Massachusetts AFL-CIO pegs the average annual state pension at $26,000. Even though that includes retirees who spent a relatively short time in state service and have other sources of retirement income, the problem in most cases is not that public-employee pensions are extravagant.

Instead, California's current fix demonstrates a fatal flaw in most public-employee pension plans. Just as employers say they need a predictable tax and business climate to invest, states need predictable cost estimates, and traditional defined-benefit pension systems make that impossible.

California assumes that its pension investments will post annual returns of 7.75 percent. When, like last year, the returns don't materialize, taxpayers either need to make up the difference or dig their kids into an even-deeper unfunded-liability hole. California's 81 percent funding level may be better than many other states, but CalPERS was 120 percent funded as recently as 2000.

Of course, the years in which returns don't meet the target are almost always during a recession, when states are least able to make up the difference. If they do, it's often at the expense of programs that provide for the neediest citizens. California Gov. Jerry Brown has made several proposals to improve the current system, but none of them would solve this fundamental problem.

It's all good when times are flush. During fiscal 2001, years of strong returns meant California taxpayers had to kick in only about $160 million to fund pensions. Just over a decade later, that number is more like $3.5 billion.

The time has come to move away from defined-benefit pensions, though it will have to happen gradually. Longer-serving employees in particular have rightly come to expect a defined pension and made decisions based on that assumption.

Alaska, Colorado, Georgia, Michigan and Ohio are among the states that already have begun, in differing degrees, to move toward defined-contribution plans. By the middle of the last decade, two-thirds of private-sector pension money was already in such plans.

The usual argument against defined-contribution plans is that they aren't fair to employees. While they do shift risk to workers, the evidence is that the long-term state employees who benefit most from defined-benefit pensions would still do well under 401(k)-type plans. According to the Employee Benefit Research Institute, "even if equity returns ... replicate the worst 50-year segment in S&P 500 history (1929-1978), 401(k) accumulations are still projected to replace significant proportions of projected income."

And there need not be just one alternative. Cash-balance pension plans, which guarantee an annual interest rate on employee contributions and the employer's match, are a viable option for more risk-averse (often older) workers. In addition to offering stability to employees, they would also provide states with the predictability they need. The interest rate on a cash-balance pension changes annually and is often tied to the return on 10-year Treasury Bills, currently around 3.25 percent. Over the past 20 years, it has averaged closer to 5 percent.

For employees, these options offer the additional advantage of fairness--benefits are tied directly to a worker's contributions. And for states already grappling with structural budget deficits and fluctuating revenue, they offer relief from existing pension systems that demand the most when taxpayers can afford it least.